This article is a resource included in our course, Dealing with IRS Tax Debt. It’s a class designed to help individuals resolve their tax debts on their own and save thousands of representation dollars. The course covers everything you need to know about your IRS income tax debt.
If you cannot pay your taxes when they are due, penalties start to accumulate. In other class resources, we detail these penalties (note - they can easily add 40% to your debt). But that’s not where the snowball stops. As penalties accumulate, another fee icings the top, forever (or until the entire balance gets paid or the Statute of Limitations kicks in – whichever comes first).
This fee? Interest.
What Balance Incurs Interest? If your taxes remain unpaid when due, penalties get added to the balance owed. The most common is the Late Payment Penalty (0.5% per month) and the Late Filing Penalty (5% per month). Then, interest accrued on the entire kit and kaboodle: Tax plus penalties, not just the tax owed. Want more bad news? The IRS charges compound interest to make your debt grow as quickly as possible. Compound Interest means interest charged gets added to the balance due. You then get charged with interest on interest!
How Much Interest Gets Charged? The amount of interest paid varies. It changes every three months (called “quarterly” by accountant types) based on the Federal Short-Term Rate plus 3%. The Federal Short-Term Rate is, generally speaking, calculated based on the average yield of US securities with maturity dates of less than three years. However, for our purpose, the Federal Short-Term rate is established by the IRS quarterly and rounded to the nearest percent. To this, add 3%, and that’s what you pay. In recent years, the rate charged by the IRS has been 3% to 5% and is currently (2022) on the increase. As interest rates rise in the general market, so does the rate charged by the IRS.
How is Interest Calculated? IRS Interest compounds daily. Daily compounding means that the rate charged gets divided by 365 days and multiplied by the balance due. Then, the product gets added to the entire balance.
For example, let’s say you owe the IRS $1,000, and the IRS rate is 4%. Take the 4% (.04) by 365 days. You get .0109589% (.000109589). Now, multiply the $1,000 by .00010989, and you’ll get $0.1095, or eleven cents rounded up. Now, on day two, you owe $1,000.11. Multiply this amount by .00010989 and add it to the 1,000.11, and you will have the amount owed on day three. Now, repeat every day after that until paid in full.
Don’t feel like doing the math? At 4%, $41 per year (or $3.42 per month) per thousand dollars owed provides a rough interest estimate.
How is Interest Paid? No, this is not a trick question. Sure, the interest gets paid when you send the money for it! But what if your tax debt includes several years of tax, penalties, and interest? How does the IRS apply your payments to each balance?
There are IRS rules governing payments. Remittances get credited in the following order:
Understanding the payment order is crucial, especially for those who agree they owe the tax but hope to have penalties abated and associated interest removed. We utilize this information in a debt-cutting strategy shared in our Dealing with Tax Debt Course. The IRS permits taxpayers to bypass the payment order and direct how payments get applied - to which year and to which debt; tax, penalties, or interest. The procedure allows you to pay the tax due while leaving penalties and interest untouched for possible reduction.
Can Interest Get Abated? Abatement means that an amount due gets reduced or forgiven. The IRS will abate penalties under certain circumstances. However, taxes and interest on those taxes generally do not qualify. There are two rare exceptions to this rule: the Partial Payment Installment Agreement and the Offer in Compromise. Both can avoid paying all due tax and related interest, but neither is technically abatement.
Dealing with IRS Tax Debt covers Partial Payment Installment Agreements. An Offer in Compromise is more complex and may require a course of its own.
Interest does not qualify for a reduction, but the IRS removes it if an underlying debt gets forgiven. For example, penalty abatement generally occurs on the assessment date. As a result, the interest gets recalculated (reduced) as though no penalty existed.
What’s the Best Way to Reduce Interest Owed? Albert Einstein (so the story goes) once called compound interest humanity’s greatest invention. Why? Because of its ability to generate astronomical wealth (or debt) from a relatively small starting balance. As stated earlier, compounding interest means that interest is charged on the interest already earned or owed. As a result, every time interest gets calculated, the amount of interest added to your balance grows. If left unchecked, at some point, the amount of interest owed is higher than the original debt.
Even at a relatively low rate of 4%, interest can grow surprisingly fast. For example, let’s say you have an unpaid tax bill of $5,000 and decide to ignore it. After five years, interest owed on the debt will grow to over $1,100. Worse yet, this calculation does not include penalties. Add the late filing and late payment penalty (plus interest), and you’d face a debt of well over $8,500 on the same $5,000.
So, short of penalty abatement, the most effective way to reduce your IRS debt is to avoid interest in the first place by paying the bill as soon as possible. Another way is to reduce the late payment penalty. Establishing an installment agreement will generally cut the late payment penalty in half, from ½% per month (6% per year) or ¼% per month (3% per year), reducing the fine and accumulating interest.
Note: The power of compound interest is also why starting to save for retirement early is so important. How much will a single $20,000 investment made when you are twenty years old be worth when you turn sixty if it earns 7% per year? A whopping $300,000 if compounded annually, $325,000 if compounding occurs monthly. Man’s greatest invention impacts both savings as well as debt!
Takeaway: The IRS has quite a few tools to punish taxpayers who cannot pay their tax obligations. These tools also incentivize payment by others. These are the late payment penalty, the late filing penalties, and interest added to the entire lot, even to interest previously charged.
Understanding how the IRS collection system works is vital when dealing with your IRS Debt. If you or someone you know owes back taxes, take the Dealing with IRS Debt training course. It is the product of 20+ years of helping clients manage their tax obligations. With a bit of instruction, most clients – and NOW YOU – manage their debt as effectively as a pro while avoiding their astronomical fees. You owe this to yourself: Check it out!
All courses and articles are for informational purposes only and do not constitute tax advice. Taxes are complicated - do not act on course information without consulting a professional. Always refer to treasury regulation before making any tax decision. Read the full disclaimer.
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